The Machines Moving the Market

There's a lot you can learn from the Terminator franchise, such as how to cope with machines taking over the world. Some humans are starting to wake up to the threat of a stock market Skynet as high-frequency trading, or HFT, achieves greater prominence. Recent regulatory efforts are attempting to cope with this poorly understood technology, but until they do, there are still ways to beat the machines at their own game.

The Terminator's an infiltration unitThe steady creep of computers into our markets is either a cause for alarm or something that's been blown out of proportion, depending on whom you ask. A recent British government study stated that "research thus far provides no direct evidence that high-frequency computer-based trading has increased volatility." Directly countering the British study, a Yale professor found a direct correlation between HFT and volatility, which gets stronger as uncertainty rises. Everyone has an angle. Is HFT like Arnold in Terminator 2, helping to save us from sinister market gyrations that vaguely resemble Robert Patrick, or is it more like Arnold from the original Terminator, an unstoppable market-killing machine?

I looked at the Dow's (INDEX: ^DJI) movements and found that while volatility still tends to track uncertainty, the market's average volume is also much higher than it used to be:

Source: Yahoo! Finance and author's calculations.Both measurements represent an average of the prior 20 trading days to smooth out irregularities.

The Dow closed up about 24% over the course of the entire decade, but daily volume more than tripled. While periods of high volatility often correspond to periods of high volume, volume was rising steadily before the 2007 crash and has remained elevated since. Sources disagree on the specifics, but most agree that HFT now accounts for between half and three-quarters of all trades in U.S. markets, up from a quarter just five years ago. Its increased use closely parallels increases in volatility.

Market judgment dayProponents of HFT argue that it can step in and buy shares during panics, preventing catastrophic volatility like 1987's Black Monday, but there's little evidence to support that claim. All but two of the decade's 20 most volatile days came during a two-month descent in 2008, from early October to the beginning of December. That's the giant spike on the chart above. The worst was Oct. 10, when the Dow yo-yoed in a 16% intraday range. Volatility wasn't contained in spite of high volume -- if anything, periods of the highest volume line up with the most volatile times. As the old saying goes, where there are murderous robots, there's fire. You've never heard that one? Just wait.

The problem isn't that HFT can create so much volume, but when it creates volume -- HFT traders don't have to buy shares if they don't feel like it. Turning off HFT systems during crises drains liquidity, removes potential buyers, and can make big drops worse. For example, the 2010 flash crash, which has become (pardon the pun) a flashpoint for anti-HFT crusaders, wasn't caused because HFT was active, but because it was turned off at a critical moment. The market tanked in minutes because no one wanted to scoop up the mess.

The resulting carnage led to the implementation of circuit breakers on many stocks, designed to halt trading if a stock drops too far, too fast. This was partly in reaction to the strange forces at work with Accenture's (NYS: ACN) and Boston Beer's (NYS: SAM) stocks that day, which both fell all the way to a single cent. If you owned either stock before the flash crash and held on, you'd be up quite a bit. Fundamentals beat volatility over the long run, and eagle-eyed investors could have gotten both stocks at substantial midday discounts.

(Don't) get outMost people hate volatility. As fellow Fool Morgan Housel pointed out, investing isn't for wusses. Timing the market will often leave you feeling like there's an unstoppable killing machine on your tail, and for good reason. Don't try to play a short-term game against a computer that can make trades in billionths of a second. The best thing you can do is to look for companies with sound fundamentals that may be suffering senseless beatdowns. The flash crash, for example, unfairly slaughtered quite a few strong stocks over the course of the day:

Source: Yahoo! Finance.* From the start of the day to the lowest point.

Apple's drop was truly inexplicable, as the company had just rolled out the iPad to great success. Imagine getting Apple stock under $200 a share, let alone in 2010. Imagine Apple dropping over 20% in one day. Crazy, isn't it? The other companies suffered similarly, with drops unconnected to any fundamental business issue. This isn't an argument for ticker-stalking your favorite companies to capitalize on a computer's mistake. Just know that random drops do occur, and the only way they should impact your investing thesis is if you can buy shares at a bargain price.

Hasta la vista, babyNo matter how often HFT moves the market, it's still fundamentally connected with real human sentiment. If you're ever lucky enough to find a company like Apple dropping for no real reason, treat it as an opportunity. Until the day that machines become sentient and take over the stock market, you'll always have the advantage of long-term perspective. Use it, but keep an eye on your iPhone. It's probably plotting something.